A Hedge Becomes Defence
Central banks and governments, depending upon the division of financial authority in a given nation, will hold significant Foreign Currency Reserves. There are many reasons to hold FX reserves. Firstly, it allows the nation to finance the capital account deficits created by its consumer, business, investment and governmental spending. Aside from facilitating international transactions at the national or common currency level, reserves also act to diversify risk in the domestic system.
To justify why foreign currency reserves have a balancing effect to sources of exogenous risk, let’s consider a nation that holds no reserve. It would be impossible to imagine a nation/government even with very low wealth per capita that would not hold significant sums of domestic currency. When an economic shock hits that country either from domestic activity (or lack thereof) or from an external source, the stockpile of wealth acts to destabilise the overall system. The value of wealth and reserves held in local currency decrease in relative value as the very currency it is held in deteriorates in buying power. This perpetuates the shock adding to its impact on the underlying economy.
When those domestic reserves of wealth become sizeable, it would therefore be sensible for a nation to take out contracts against its own currency or indeed diversify the underlying physical holdings into a foreign currency. When domestic currency reserves are too low in comparison to foreign reserves, instead of printing money, a nation can do the opposite: sell foreign reserves in favour of its own currency. This avoids the inflationary effects of quantitative easing that are very unpalatable for most nations in today’s financial environment. For a net importing nation, such activities can even help to reduce inflationary pressures imported from overseas.
Queue Sweden. A lot of chatter has taken place about the prospect of Sweden’s central bank buying the Krona and selling some of its international reserves. Figures of up to $6bn have been discussed as up for sale within FX forwards in the coming months. This is a timely debate with FX intervention being heavily discussed and driving significant volatility in the Yen last week.
Discussion and Analysis by Charles Porter
Click Here to Subscribe to the SGM-FX Newsletter
Related Insights
Daily Brief – British pound
Humphrey Percy
Fri 13 Jun 2025
British pound Sterling finds itself in the limelight and trading at its recent highs as somewhat improbably a couple of bolder market commentators have suggested the UK will benefit as a result of the disaffection with the USA and the USD at present. Those commentators have obviously not been following the commentary about UK Chancellor […]
Daily Brief – Oil Supply
Humphrey Percy
Mon 16 Jun 2025
Oil Supply With Friday’s rocketing up in the oil price of 12% to $78, the question is whether that is it and we have just seen a re-set or whether this is the first staging post in a much larger increase. That, of course, depends on the unfolding Israel-Iran attacks and whether that conflict spreads […]
Daily Brief – EU Inflation
Humphrey Percy
Wed 4 Jun 2025
EU Inflation Paving the way for a 25bp rate cut tomorrow, EU inflation came in at 1.9% on the back of uncertainty, lack of consumer confidence and people sitting on their cash. So overall good on inflation but a sign of less good things in the EU. As ever, the overall inflation figure had some […]
